A random wolf on Wall Street could calm stock markets

STOCK market investors who buy and sell on the flip of a coin might sound irresponsible, but a handful of random traders could be just what markets need to avoid bubbles and subsequent crashes.

Financial booms and busts occur when traders all rush to purchase or sell stock just because others around them are. “I see someone investing, I suppose that they probably have more information than me,” says Alessandro Pluchino of the University of Catania, Italy.

Pluchino and his colleagues wondered whether it was possible to stop this cascade of copycat behaviour by introducing a random element – traders who ignore all available information and instead buy or sell with equal probability.

To find out, the team simulated a network of 1600 traders betting on whether the Standard & Poor’s 500 index would go up or down – a proxy for buying and selling activity – based on historical data. At every step in the simulation, each trader tries to predict the movement of the index on the next step. Traders have a quantity of information about the market and use this to inform their prediction. The traders take into account the bets their neighbours make and may revise their own on the next step as a result. This can lead to a chain reaction of bets and thus bubbles and crashes. The team attempted to combat these events by introducing traders who don’t accept or transmit information and bet randomly instead.

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They found that increased numbers of coin-flipping investors reduced the size and frequency of extreme financial events (Physical Review E, doi.org/q4d). In the real world, Pluchino says central banks could take on the role of random traders to calm markets.

“It is an interesting model which draws some interesting implications,” says Andy Haldane, executive director for financial stability at the Bank of England. However, long-term investors like pension funds and insurance companies should already serve a random-trading role in the market, he says. Central banks might not need to step in at all, he adds, as “circuit breakers” that slow trading-feedback loops can quash crashes. “Many stock markets have just these features.”